On Sept. 15, Ethereum underwent a key network update. It changed from its proof-of work (PoW), mining consensus, to a Proof-of-stake one. The Merge is the key upgrade.
The Merge was intended to be a major change in the Ethereum network, making it more efficient and allowing for future improvements in scalability as well as decentralization.
However, a little more than a month later, industry observers worry that the PoS transition has led Ethereum to greater centralization and increased regulatory scrutiny.
The Merge changed the way transactions on the Ethereum network were verified. Instead of miners contributing their computational power to verify a transaction, validators now pledge Ether ( and ETH tokens to verify that transactions. This system has a problem: validators who have more Ether or staked ETH have more say.
A minimum 32 ETH is required to become a validator of the Ethereum network. To have a greater share of validator nodes, whales and large crypto exchanges must stake millions of ETH.
The current staking activity is very centralized, with Lido, the liquid staking protocol, and major centralized exchanges like Coinbase, Kraken, and Binance accounting for more than 60% of staked Ethereum.
Cointelegraph was told by RA Wilson (chief technology officer at 1GCX crypto and carbon credit exchange 1GCX) that the Merge allowed large holders of Ether control over the network. This makes it more centralized and less secure.
“Many ETH holders hold their crypto on centralized platforms such as Coinbase. This allows them to become dominant holders of the network and contributes to stakeholder centralization.”
After the Merge, the centralization aspect was very evident. 46.15% all nodes used for data storage, transaction processing, and the creation of new blocks in blockchain could be attributed only to two addresses.
Cointelegraph was told by Vetle Lunde, an Arcane Crypto analyst that the PoS transition was crucial for Ethereum’s long term goals of energy efficiency as well as scalability. However, it is important to be aware of the tradeoffs.
The largest validators are exchanges, which could pose a long-term risk. The regulatory environment for exchanges is already difficult. Preventive rejections of transactions could be a violation of censorship resistance, which is a core principle of the crypto ethos.
Although Ethereum supporters claim that anyone can become a validator with 32 Ethereum, it is important that you note that 32 Ethereum, which is around $41,416, does not seem to be a lot for a novice or common trader. Also, the lock-in period is very long.
Slava Demchuk (CEO of Web3 complaint platform PureFi), told Cointelegraph that the centralization involved in staking would make centralized entities such as Coinbase more powerful.
“Due to its simplicity and lack of 32ETH, most people will choose Coinbase as their custodian. Large companies will control a larger share of the network and it will be more centralized. This means entities with more ETH have greater control.
Fear of regulatory scrutiny
In 2018, the SEC stated that Ether was not a security due to its decentralized development process and rapid expansion. This could change due to the introduction of PoS, which has complicated relations between regulators and the Ethereum blockchain.
On the day of Merge, Gary Gensler (Chair of the United States Securities and Exchange Commission) testified before Senate Banking Committee. He stated that revenue from “expectation for profit to be derive from the efforts of other” would include proof of-stake digital assets.
Gensler mentioned that staking on large centralized exchanges is “very similar to lending”, calling out high yield products that caused the recent cryptocurrency market crash and lumping them into financial instruments under scrutiny by the SEC.
A week after the Merge, a lawsuit was filed by the SEC claiming jurisdiction over the Ethereum network. The majority of nodes in the United States are covered by the suit.
Although the SEC’s claims were controversial and many criticised the regulator for their approach, others believe Ethereum had it coming. Gensler already stated that the move to PoS could lead to securities laws. Ruadhan, who is the main developer of Seasonal Tokens, a PoW-based mining token, said to Cointelegraph:
“The argument that validators are concentrated in the U.S. is weak, as it is not even a majority. This move shows an intention to regulate and would cause major disruption to the economy, if Ethereum was to be classified as security. The central exchanges would have to de-list Ethereum. The global economy is very fragile at the moment, and Ethereum’s market capital is so large that an event such as this could have ripple effects and even lead to an economic crisis.
Ruadhan predicted, “If Ethereum were classified as security, then it will be more heavily regulated regardless how central it is.”
Cointelegraph was told by Kenneth Goodwin (director of regulatory and institution affairs at Blockchain Intelligence Group) that the SEC has leveraged the move to PoS to oversee validators as well as the nodes as long as they are connected to a U.S. entity, person, or jurisdiction. But there’s a paradox to this situation. Goodwin explained:
The irony is that this network could be considered for the U.S. central banks digital currency, given its centrality. The flip side is that there would be greater regulatory oversight, including the creation of a registration system for validators and Ether protocol projects. It seems that the SEC wants to classify Ethereum security.
Jae Yang, CEO of Tacen, a noncustodial cryptocurrency exchange, said to Cointelegraph that centralization could be a problem for Ethereum if regulators impose Anti-Money Laundering regulations on staking.
“Centralization is a concern if FinCEN and other regulators impose Know Your Customer or AML compliance requirements for users just staking ether. Although it is unlikely at this time, there is a danger that central validators may omit transactions and establish themselves as third-party intermediaries on decision-making, which goes against the very principles of the decentralized financial systems.” he said.
PoS Transition’s long-term effects
Industry observers believe that Ethereum blockchain will overcome concerns about over-centralization, regulatory scrutiny, and continue to play an important role in the development of the ecosystem long-term.
Jason Lau, chief operating officer at Okcoin, argued for a broader view of the transition. Cointelegraph was informed by him:
When we consider the debate between centralization and decentralization, it is important to think long-term. To ensure security, censorship resistance, openness, and security, open blockchains must have a high degree of decentralization. Any shift towards greater centralization is worth watching. We will watch how the community reacts to changes in participants over time.
Wilson pointed out that the network could become slightly decentralized in the coming 6-8 months as lock-up periods for Ethereum expire. Holders will then be able withdraw staked tokens.
While centralization of node and validator is a concern, Chen Zhuling (co-founder and CEO noncustodial Staking Service Provider RockX) noted that PoW mining on Ethereum was just as centralized than validators of the current PoS network.
Chen explained to Cointelegraph that during the PoW era “Three mining pool dominated the Ethereum network’s hashrate.” If you don’t have a lot of computing power, it is difficult to compete with other miners for verifying blocks. This requires expensive, high-energy mining rigs.
Chen advocated for a long-term approach to the PoS transition. Currently, tokens are controlled by large foundations for security reasons and the goodwill assumption that they won’t corrupt the network.
Demchuk quickly pointed out that the centralization of staking does NOT mean that it will be easy to take over the Ethereum network by a large group of malicious stakers. “There is an additional protection measure.” Bad validators can have their stake confiscated.
Although Ethereum may have become a PoS network, the majority of the scalability features and other features will not be available until the end of the final phase. This is expected to happen by 2024.
It will be fascinating to see how Ethereum addresses regulatory concerns and overcomes centralization of validators in the future.